The Development of Private Equity and Venture Capital

The history of private equity is mainly set in the 20th Century and shows fluctuations along the way. Its development steams from the United States and reached Europe and Hungary only in the most recent decade. In order to understand the present status of venture capital and private equity it is useful to briefly recapitulate the industry’s past.

The Origins

The inception of private equity can be traced back as early as the industrial revolution. At this time investors had already been engaged in investing in privately held companies as well as in acquiring businesses. J. Pierpont Morgan himself purchased Carnegie Steel Co. from Andrew Carnegie and Henry Phipps for $480 million in 1901 – to this day this is regarded as the first major buyout. Towards the beginning of the 1900s J.P. Morgan’s company would engage in financing of industrial companies and railroads. Before World War II, the domain of private equity financing was in the hands of wealthy individuals and families such as the Rockefellers, Vanderbilts and Warburgs.

The Early History

It is the establishment of the American Research and Development Corporation (ARDC) in 1946 that marks the rise of professionally managed private equity investments. This was a publicly traded and closed-end investment company with a view to offer a private-sector financing for new and small businesses. Private equity investments around this time would often be founded on an ad-hoc basis.

The real boost to private equity capital came with the passage of two pieces of legislation in the United States. Section 1244 of the Internal Revenue Code allowed for a write off of capital losses against ordinary income for those individuals who invested at least $25,000 in small new businesses and the Small Business Investment Act of 1958 established Small Business Investment Companies. In five years these companies raised near fifty times the amount raised by ARDC in thirteen years.

The 1960s saw the formation of venture capital limited partnerships. Though small, by the end of the decade these partnerships had already raised $171 million. 1969 brought with it an increase in capital gain tax rates and the diminishment of the market for initial public offerings. This time the focus shifted away from financing new ventures to expanding companies that were already in the private equity managers’ portfolios.

The concept of private equity itself came about through the emergence of KKR: the investments of Jerome Kohlberg Jr., Henry Kravis and George Roberts in family-owned businesses facing succession issues. These companies faced both a lack of viable exit options and the ability to be taken public due to their small size. Instead selling these companies to competitors the founders would often decide it to be better to sell to a financial buyer.

The Boost to Bust periods

1980s to the early 1990s

Due to changes in the regulatory and tax systems the private equity market soared in these years. The growth was most prominent in non-venture private equity, but venture capital also experienced a boost. Apple Computer, Compaq, Federal Express, Genetech and Intel are all firms that experienced major venture capital investments at the time. It is not an exaggeration to conclude that this era transformed Santa Clara Valley into the conceptual Silicon Valley as venture capital expanded the electronic, medical, data-processing industry and technology through firms based there.

It is estimated that in the 80s, there were more than 2,000 leveraged buyouts valued in excess of $250 million. These included the Federated Department Stores, Revco Walter Industries, and notably the $31.1 billion dollar takeover of RJR Nabisco by KKR. However, by the 1990s apart from RJR Nabisco all those buyouts experienced bankruptcy with KKR having to recapitalize in order to avoid such disasters.

1992 to 2002

It was the acquisition of Snapple Beverages in 1992 that is often seen as marking the beginning of a new growth in the venture capital market with Thomas H. Lee Partners selling the company to Quaker Oats for $1.7 billion.

This was also the era that saw the growth of technological firms such as Apple Inc. and Microsoft. Venture capital also stood behind the likes of Amazon.com, E-bay, Netscape and Yahoo! However, after the Nasdaq crash in 2000, a period was put at the end of the dot-com era when valuations for startup technology companies crumbled.

2003 to 2007

Once the dot-com bubble burst, low interest rates once again resurrected the private equity industry. In fact, this was the time that the world witnessed the largest leveraged buyouts, massive expansion in private equity activity, and the growth of huge, institutional-sized private equity firms among which were the likes of The Blackstone Group and the Carlyle Group. However, the boost was not restricted to the US this time: Europe also took part in it.

By 2007 the mortgage market suffered a crisis that could not be quarantined from the leveraged financial world. By early fall that year lenders such as Citigroup announced substantial writedowns due to credit losses. The credit crunch prompted buyout firms to pursue different groups of transactions.

2008 to the Present

By 2008 the credit markets froze. This affected the private equity market which always had a substantial dependency on the access to bank loans in order to finance their investments. As capital markets suffered from stagnation, private equity investments also grinded to a halt.

However, during this period of sidelining, private equity firms managed to accumulate substantial funds. In 2010 private equity deals picked up once again and so these funds could be used during the auction of private equity assets that were on sale once again.

The Future

Venture capital is yet to see many challenges in 2012. However, if the portfolio companies and private equity firms succeed in making it through the hard times – as history will teach us – prosperous times may not be that far away!